Bigamy, grave robbing and passing false cheques are pretty much the only crimes that Ben Bernanke and the Federal Reserve have not been accused of in the past few weeks.

Since the US central bank launched its $600bn round of asset purchases at the start of November, its critics have not hesitated to accuse it of recklessness, incompetence and conspiracy to devalue the dollar, often in vitriolic terms.

Wolfgang Schäuble, the German finance minister, called the Fed “clueless” and accused it of steering “the dollar exchange rate artificially lower”. Republicans in Congress decried a Fed policy that, through some voodoo, they think will not only fail to stimulate the economy but will also create inflation.

Last week’s Fed “data dump” – revealing details of 21,000 transactions with banks during the financial crisis from 2007-2009 – has prompted accusations that the Fed bailed out foreigners or lent against dodgy collateral.

There are legitimate criticisms of the Fed, but many of these attacks could be turned back on the attackers.

Start with the dollar. All else being equal, some fall in the exchange rate is the inevitable consequence of the easing of monetary policy, always and everywhere.

Yet since the start of November the euro has depreciated by about 5 per cent against the dollar, prompted in large part by Germany’s insistence on talking about future mechanisms to restructure eurozone sovereign debt in the middle of a eurozone sovereign debt crisis.

Then there is the political criticism that the Fed’s asset purchases will lead to runaway inflation. Central bank purchases of government bonds can do this – but only in cases when politicians run a persistent fiscal deficit and then force the central bank to finance it.

“The Federal Reserve hasn’t gotten the message. Printing money is no substitute for sound fiscal policy,” said Mike Pence, a leading Republican in the House of Representatives, last month.

Quite right, the Fed might say, now how about that sound fiscal policy? Even as members of Congress attack the Fed, they are moving towards an extension of Bush-era tax cuts on all income levels that will add about $3,700bn to the deficit if continued over the next 10 years.

The official deficit commission run by Erskine Bowles and Alan Simpson came up with a plan that, like it or not, would deal with the deficit. It did not win sufficient bipartisan support. Congress is adding more than its share to long-term inflation risks in the US.

Finally, consider the fallout from the Fed’s data release last week. “After years of stonewalling by the Fed, the American people are finally learning the incredible and jaw-dropping details of the Fed’s multi-trillion-dollar bail-out of Wall Street and corporate America,” said Bernie Sanders, an independent senator from Vermont.

Two of the biggest criticisms are that the Fed lent against the questionable collateral of low-rated debt and that much of its help went to foreign banks. There is no doubt that the Fed took risks.

If Congress had not come through with the $700bn troubled asset relief programme then the results for the central bank would have been unpleasant.

But the point of the Fed’s lending was to provide liquidity to markets that had frozen up. It could not have done this if it had only been willing to lend against Treasury bonds, which were almost the only asset that remained liquid throughout the crisis without Fed help.

Heavy use of Fed facilities by foreign banks reflects the global role of the dollar and the intense demand for US currency during the crisis. Denying liquidity to overseas central banks and to the New York branches of foreign banks would have been a quick way to end that global role. It might also have forced foreigners to default on their obligations to American banks.

At least the Fed’s rescue worked: it was paid back in full, with interest, on all its emergency loans and prevented a devastating financial collapse. Would that Ireland – where bank losses have overwhelmed the government’s finances – could say the same.

Friday, December 3, 2010

Republicans are pressuring the Federal Reserve to shift away from the dual mandate of price and output stability and focus primarily on price stability. They argue as the Fed has focused on creating more jobs it has come at the possibility of higher inflation.

Most of the recent criticism has come after the announcement for a second round of quantitative easing. I am a bit baffled by the recent push for a single mandate of price stability. If the Federal Reserve had a single mandate of price stability, would monetary policy be any different from today. Bernanke, perhaps more than anyone else, understands the risk an economy faces in the event of a debt-deflation spiral. His research has been instrumental in helping policymakers understand the risks associated with a large decline in prices. Following the housing crisis, the U.S. consumer faced record levels of debt. If prices decline, debt increases in real terms. If the economy would have entered a period of 2-3% of deflation, the real interest rate would have increased by 2-3%. Wages would have declined while mortgage, car, and loan payments stayed the same. That is a receipt for a disaster. We would have experienced drastic increases in household and bank defaults.

As much as Republicans want to change the mandate of the Federal Reserve, it would not change how they have conducted policy. Inflation rates are well below their target of 2-3%. Greg Mankiw, a conservative economics has also voiced his opinion on the matter:

I am skeptical. If the Fed's mandate were different, monetary policy today might well be the same. That is, with inflation now below its target, the Fed could be pursuing QE2 even if it were operating under the proposed mono mandate. Looking ahead, the Fed believes that inflation too low, even deflation, is a larger risk than inflation too high, so it is engaging in expansionary policy to get inflation back on target.

My view is that QE2 is a modestly good idea. I say it is a "good idea" because, like Ben Bernanke, I am more worried at the moment about Japanese-style deflation and stagnation than I am about excessive inflation. By lowering long-term real interest rates below where they otherwise would be, QE2 should help expand aggregate demand. I include the modifier "modestly" because I don't expect these actions to have a very large effect.

I think Congress is looking for someone else to blame instead of focusing on their own problems. Instead of blaming the Federal Reserve for doing something, perhaps they should focus on using fiscal policy to improve the economy. They need to be finding way to increase spending, cut taxes today and reducing the national debt over the next ten years. Going after the Fed tells me they are trying to avoid more pressing issues.

Well this is not good news. The unemployment rate has increased to 9.8% for November. The economy added 39,000 which is below the expected 150,000 jobs that were forecasted. Part of the increase is from discouraged workers reentering the labor force. The labor force increased by 100,000 workers, but the number of unemployed increased by 250,000.

Wednesday, December 1, 2010

I tend to disagree is Krugman on structural unemployment. He views the current increase in unemployment as entirely cyclical (in his mind the economy has a natural rate around 5%), while I view the increase in unemployment as increases in structural and cyclical (in my mind the economy has a natural unemployment rate around 6.5-7%). Krugman goes on to say:

As far as I can tell, the only economists who believe that we’re suffering largely from a rise in structural unemployment are those who are ideologically committed to the view that the demand side of the economy doesn’t matter — and so by definition, in their universe, any large rise in unemployment must be structural.

Well, I believe the demand side does matter and we have an increase in structural unemployment. The difference between Krugman and myself is where we see potential output, mainly during the housing boom. Krugman's argument implicitly assumes the economy was operating at potential output during the housing boom. I believe the economy was operating slightly above potential during the same time period. In other word, the 5% unemployment in the economy was because cyclical unemployment was negative. If you go back to 2000, you'll see large decreases in the manufacturing employment. This is the exact definition of structural unemployment. These workers do not have the skills needed to find employment in the current economy. During the housing bubble, the construction industry was clearly operating above it's potential) took on the unemployed manufacturing workers. Today employment in the construction industry has returned to pre-bubble levels, and we're left with 8 million unemployed manufacturing workers.

In economic jargon, the supply curve of labor was flat but is now sloping upward, so that rapidly increasing demand for labor resulting from rapid growth is driving up wages. That means that China is beginning to “rejoin the human race” as capital accumulation meets scarcer labor and growth slows.

No, well yes, okay maybe. It depends are you a buyer or a seller. Housing prices declined by 2% during the third quarter, but for most of 2009 and 2010 have remained stable. I expect this is be part of the new normal. Housing prices should increase at the same rate as inflation (1-2% annually). A lot of the price changes will have to do with the interest rates. With low interest rates, I'm surprised prices didn't increase a little, but with a fixed population there is no reason to expect housing prices will increase at a faster rate, unless we end up in another housing bubble.

Tuesday, November 30, 2010

Here are a couple articles discussing potential changes in the tax code. The first one is review of the key findings by the debt commission. The second article discusses the differences between deficits and debt (which everyone should know).

We've talked in class about QE1, the decision for the Federal Reserve to buy long-term debt instruments to lower the yield curve. Here is a nice review of the process.

Politically QE2 has drawn a lot of heat. So is it good, bad or somewhere in between. My views tend to follow those of Greg Mankiw. I see QE2 with some potential upside by lowering interest rates on mortgages, student loans, and government debt and trying to prevent deflation. Remember we want to see inflation rates around 2%, they are still well below 1% as the economy sputters along. The skeptics point to QE2's potential for cause high inflation in the future. Of course these same skeptics were calling for high inflation after QE1 (back in March of 2009). Clearly, they were wrong the first time (evident by the need for QE2) and I suspect will be wrong the second time. QE1 consisted of $1.25 trillion in debt purchases (government bonds and mortgage backed securities) meanwhile the Fed announced QE2 will result in $600 billion (less than half of QE1).

The concern is not high inflation, the Federal Reserve will not let inflation go above 3-4%. The concern is the cost of preventing high inflation. The Federal Reserve has the ability to reign in the money supply (remember banks use the excess cash from the Fed to make loans, as loans increase the money supply increases) and prevent prices for drastically increasing. They can raise interest rate on reserve holdings. Banks are currently earning 0.25% on their reserves, it would be easy for the Fed to offer a higher right and entice banks to keep reserves with the Fed. Second the Fed can buy back the cash through open market sales. Finally, they could raise the reserve requirement. All three choices would be costly, not only will the Fed take a loss on their open market purchases they would have to pay out a large sum in interest payments. This is the least of my concern. So what if they take a $10-50 billion loss (last year they made more than that on the purchases). The bigger concern would be the effect on a struggling economy. A sudden increase in interest rates (from the debt sell off) could send us back into another recession.

The Fed's actions have probably prevented a double dip recession, made borrowing extremely cheap, and saved taxpayers $100+ billion in future interest payments on the debt. A 1-2% reduction in bond yields means cheap financing for the government when they have issued will over $5 trillion in government bonds these last few years. The a sudden reversal in policy will ultimately cause the double dip recession. I don't necessarily see the latter likely to occur. So in my take the benefit outweighs the cost.

Tuesday, November 23, 2010

GRADES:
I have updated the grades on the webpage. There are a couple of items I would like to point out. I've separated your scores into four categories (homework, quizzes, blog, and final exam). You will notice that I have tallied the total points earned for each component. To date you have completed nine homework assignment, seven scores are being counted for a total of 140 points. This means you have 60 points left to earn. You have completed four quizzes, three scores are being counted for a total of 300 points which means you have 100 points left to earn. You can enter in the scores for each component to see how many points you need on homework, the final quiz, blog posts, and the final exam for a particular grade. Remember there are 1000 points in the class. The grade break down is available on the syllabus.

On the second sheet you will notice your raw scores for homework assignments and quizzes and your current percentage in the class (far column). Please make sure these are correct. On the third sheet you will see your blog posts. I have updated the blog scores through today, but when calculating your grade I went through week 12 since a number of people have not posted this week.

HOMEWORK:
There is a homework assignment due Sunday night at midnight. For those that attended class on Monday the assignment should be very straightforward. For the 45 students that did not attend class you will need to read the first part of chapter 13 on aggregate demand. We will briefly review aggregate demand before getting into aggregate supply on Monday after Thanksgiving.

QUIZ:
There is one quiz left. It will be Wednesday, December 8th. As we discussed in class on Monday, the quiz can not lower your grade. You will receive the higher of average of your three highest scores or your score on quiz 5. For example, suppose your average for your highest three quizzes is 85% and you score a 75% on the quiz, your score for quiz 5 will be an 85, but if you score a 90% your score will be a 90.

For those struggling to understand the relationship between the yield curve and monetary policy this article does a really nice job of summarizing everything. This will help answer questions 1 and 2 in chapter 11.

Sunday, November 14, 2010

Think you can solve the government's budget deficit. Give it a try by going here.

Notice the biggest savings comes from increasing medicare and social security age and by removing the tax benefits employers receive by providing employees health care.

Sidebar: Have you ever wondered why employers provide health care? Well they can offer you health care and it comes tax free. Why not give workers the income they have earned and let them decide which health care program best suits their needs. It would save $150 billion over the next 20 years.

Monday, November 8, 2010

Oil prices are responding to the Federal Reserves recent announcement for further quantitative easing. Oil is a global commodity that is denominated in dollars. As the Federal Reserve continues pumping money into the economy and the dollar depreciates oil producing countries are finding themselves with decline oil revenues. I've always said that the economy will continue in it's recovery (albeit weak) as long as oil prices stay under control. High oil prices place greater burdens on households and weaken an already low consumer confidence. This could spell trouble with the upcoming travel season.

It looks like American's are continuing this push to a new normal. American's have paid off nearly $1 trillion in debt, are taking out fewer credit cards, and mortgage debt is in decline. Now only if the government could do the same (at least in the future have some plan to pay down the debt).

Sunday, November 7, 2010

Is the economy going into a second recession? The evidence suggests the economy will not reenter into another recession.

The biggest concern is the high levels of long-term unemployment. I don't see this causing another significant slowdown in the short-run. Instead I think the economy is going to adjust to a new level of economic growth. Instead of growing at 3% we'll grow at a 2% average. I view this as more of a structural problem. Households will continue to save, the natural rate of unemployment will increase, but the economy will grow.

Like every policy there are costs and benefits. The costs are clear, injecting large amounts of reserves into the financial system can create high inflation. In the last month inflationary expectations have started to increase (remember TIPS had negative yields, because inflation is factored in as a coupon payment). This is good. One way to get businesses investing is to raise the future price of capital goods. Businesses can take advantage of low interest rates today (both low nominal and real interest rates) and high output prices in the future. It is a win, win. Of course they are not taking advantage of the low interest rates, why?

My thoughts, the economy still sticks. There is a lot of uncertainty surrounding future government policy and consumer spending. Will the tax cuts be extended? Will consumer continue to ratchet back spending? These factors play a key role in the profitability of any investment.

This letter has been posted on some economics blogs and I thought it was interesting (yes I'm a dork, I read economic blogs and thought the letter was interesting). Points 16, 17, and 18 are of particular interest given the day.

18, Norham Gardens
Oxford, England
16. xii. 33.

In response to the New York Times' request for his views on the American outlook, Keynes has written "An Open Letter to President Roosevelt," which is scheduled to appear in the Sunday issue of December 31st and is to be syndicated in other parts of the United States.

So that you may see what he has to say before it is published, Keynes this morning sent me the enclosed copy of his article, which I hasten to get off directly to you through Miss LeHand (without forwarding it through the pouch) in the hope that it may catch the Bremen, which leaves tonight.

Yesterday's Times carried illuminating extracts from Wallace's Annual Report. What a good Secretary of Agriculture you have!

You have made yourself the Trustee for those in every country who seek to mend the evils of our condition by reasoned experiment within the framework of the existing social system. If you fail, rational change will be gravely prejudiced throughout the world, leaving orthodoxy and revolution to fight it out. But if you succeed, new and bolder methods will be tried everywhere, and we may date the first chapter of a new economic era from your accession to office. This is a sufficient reason why I should venture to lay my reflections before you, though under the disadvantages of distance and partial knowledge.

At the moment your sympathisers in England are nervous and sometimes despondent. We wonder whether the order of different urgencies is rightly understood, whether there is a confusion of aim, and whether some of the advice you get is not crack-brained and queer. If we are disconcerted when we defend you, this may be partly due to the influence of our environment in London. For almost everyone here has a wildly distorted view of what is happening in the United States. The average City man believes that you are engaged on a hare-brained expedition in face of competent advice, that the best hope lies in your ridding yourself of your present advisers to return to the old ways, and that otherwise the United States is heading for some ghastly breakdown. That is what they say they smell. There is a recrudescence of wise head-waging by those who believe that the nose is a nobler organ than the brain. London is convinced that we only have to sit back and wait, in order to see what we shall see. May I crave your attention, whilst I put my own view?

You are engaged on a double task, Recovery and Reform;--recovery from the slump and the passage of those business and social reforms which are long overdue. For the first, speed and quick results are essential. The second may be urgent too; but haste will be injurious, and wisdom of long-range purpose is more necessary than immediate achievement. It will be through raising high the prestige of your administration by success in short-range Recovery, that you will have the driving force to accomplish long-range Reform. On the other hand, even wise and necessary Reform may, in some respects, impede and complicate Recovery. For it will upset the confidence of the business world and weaken their existing motives to action, before you have had time to put other motives in their place. It may over-task your bureaucratic machine, which the traditional individualism of the United States and the old "spoils system" have left none too strong. And it will confuse the thought and aim of yourself and your administration by giving you too much to think about all at once.

Now I am not clear, looking back over the last nine months, that the order of urgency between measures of Recovery and measures of Reform has been duly observed, or that the latter has not sometimes been mistaken for the former. In particular, I cannot detect any material aid to recovery in N.I.R.A., though its social gains have been large. The driving force which has been put behind the vast administrative task set by this Act has seemed to represent a wrong choice in the order of urgencies. The Act is on the Statute Book; a considerable amount has been done towards implementing it; but it might be better for the present to allow experience to accumulate before trying to force through all its details. That is my first reflection--that N.I.R.A., which is essentially Reform and probably impedes Recovery, has been put across too hastily, in the false guise of being part of the technique of Recovery.

My second reflection relates to the technique of Recovery itself. The object of recovery is to increase the national output and put more men to work. In the economic system of the modern world, output is primarily produced for sale; and the volume of output depends on the amount of purchasing power, compared with the prime cost of production, which is expected to come n the market. Broadly speaking, therefore, and increase of output depends on the amount of purchasing power, compared with the prime cost of production, which is expected to come on the market. Broadly speaking, therefore, an increase of output cannot occur unless by the operation of one or other of three factors. Individuals must be induced to spend more out o their existing incomes; or the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees, which is what happens when either the working or the fixed capital of the country is being increased; or public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money. In bad times the first factor cannot be expected to work on a sufficient scale. The second factor will come in as the second wave of attack on the slump after the tide has been turned by the expenditures of public authority. It is, therefore, only from the third factor that we can expect the initial major impulse.

Now there are indications that two technical fallacies may have affected the policy of your administration. The first relates to the part played in recovery by rising prices. Rising prices are to be welcomed because they are usually a symptom of rising output and employment. When more purchasing power is spent, one expects rising output at rising prices. Since there cannot be rising output without rising prices, it is essential to ensure that the recovery shall not be held back by the insufficiency of the supply of money to support the increased monetary turn-over. But there is much less to be said in favour of rising prices, if they are brought about at the expense of rising output. Some debtors may be helped, but the national recovery as a whole will be retarded. Thus rising prices caused by deliberately increasing prime costs or by restricting output have a vastly inferior value to rising prices which are the natural result of an increase in the nation's purchasing power.

I do not mean to impugn the social justice and social expediency of the redistribution of incomes aimed at by N.I.R.A. and by the various schemes for agricultural restriction. The latter, in particular, I should strongly support in principle. But too much emphasis on the remedial value of a higher price-level as an object in itself may lead to serious misapprehension as to the part which prices can play in the technique of recovery. The stimulation of output by increasing aggregate purchasing power is the right way to get prices up; and not the other way round.

Thus as the prime mover in the first stage of the technique of recovery I lay overwhelming emphasis on the increase of national purchasing power resulting from governmental expenditure which is financed by Loans and not by taxing present incomes. Nothing else counts in comparison with this. In a boom inflation can be caused by allowing unlimited credit to support the excited enthusiasm of business speculators. But in a slump governmental Loan expenditure is the only sure means of securing quickly a rising output at rising prices. That is why a war has always caused intense industrial activity. In the past orthodox finance has regarded a war as the only legitimate excuse for creating employment by governmental expenditure. You, Mr President, having cast off such fetters, are free to engage in the interests of peace and prosperity the technique which hitherto has only been allowed to serve the purposes of war and destruction.

The set-back which American recovery experienced this autumn was the predictable consequence of the failure of your administration to organise any material increase in new Loan expenditure during your first six months of office. The position six months hence will entirely depend on whether you have been laying the foundations for larger expenditures in the near future.

I am not surprised that so little has been spent up-to-date. Our own experience has shown how difficult it is to improvise useful Loan-expenditures at short notice. There are many obstacle to be patiently overcome, if waste, inefficiency and corruption are to be avoided. There are many factors, which I need not stop to enumerate, which render especially difficult in the United States the rapid improvisation of a vast programme of public works. I do not blame Mr Ickes for being cautious and careful. But the risks of less speed must be weighed against those of more haste. He must get across the crevasses before it is dark.

The other set of fallacies, of which I fear the influence, arises out of a crude economic doctrine commonly known as the Quantity Theory of Money. Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed. Some people seem to infer from this that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States to-day your belt is plenty big enough for your belly. It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor.

It is an even more foolish application of the same ideas to believe that there is a mathematical relation between the price of gold and the prices of other things. It is true that the value of the dollar in terms of foreign currencies will affect the prices of those goods which enter into international trade. In so far as an over-valuation of the dollar was impeding the freedom of domestic price-raising policies or disturbing the balance of payments with foreign countries, it was advisable to depreciate it. But exchange depreciation should follow the success of your domestic price-raising policy as its natural consequence, and should not be allowed to disturb the whole world by preceding its justification at an entirely arbitrary pace. This is another example of trying to put on flesh by letting out the belt.

These criticisms do not mean that I have weakened in my advocacy of a managed currency or in preferring stable prices to stable exchanges. The currency and exchange policy of a country should be entirely subservient to the aim of raising output and employment to the right level. But the recent gyrations of the dollar have looked to me more like a gold standard on the booze than the ideal managed currency of my dreams.

You may be feeling by now, Mr President, that my criticism is more obvious than my sympathy. Yet truly that is not so. You remain for me the ruler whose general outlook and attitude to the tasks of government are the most sympathetic in the world. You are the only one who sees the necessity of a profound change of methods and is attempting it without intolerance, tyranny or destruction. You are feeling your way by trial and error, and are felt to be, as you should be, entirely uncommitted in your own person to the details of a particular technique. In my country, as in your own, your position remains singularly untouched by criticism of this or the other detail. Our hope and our faith are based on broader considerations.

If you were to ask me what I would suggest in concrete terms for the immediate future, I would reply thus.

In the field of gold-devaluation and exchange policy the time has come when uncertainty should be ended. This game of blind man's buff with exchange speculators serves no useful purpose and is extremely undignified. It upsets confidence, hinders business decisions, occupies the public attention in a measure far exceeding its real importance, and is responsible both for the irritation and for a certain lack of respect which exists abroad. You have three alternatives. You can devalue the dollar in terms of gold, returning to the gold standard at a new fixed ratio. This would be inconsistent with your declarations in favour of a long-range policy of stable prices, and I hope you will reject it. You can seek some common policy of exchange stabilisation with Great Britain aimed at stable price-levels. This would be the best ultimate solution; but it is not practical politics at the moment unless you are prepared to talk in terms of an initial value of sterling well below $5 pending the realisation of a marked rise in your domestic price-level. Lastly you can announce that you will definitely control the dollar exchange by buying and selling gold and foreign currencies so as to avoid wide or meaningless fluctuations, with a right to shift the parities at any time but with a declared intention only so to do either to correct a serious want of balance in America's international receipts and payments or to meet a shift in your domestic price level relatively to price-levels abroad. This appears to me to be your best policy during the transitional period. In other respects you would regain your liberty to make your exchange policy subservient to the needs of your domestic policy--free to let out your belt in proportion as you put on flesh.

In the field of domestic policy, I put in the forefront, for the reasons given above, a large volume of Loan-expenditures under Government auspices. It is beyond my province to choose particular objects of expenditure. But preference should be given to those which can be made to mature quickly on a large scale, as for example the rehabilitation of the physical condition of the railroads. The object is to start the ball rolling. The United States is ready to roll towards prosperity, if a good hard shove can be given in the next six months. Could not the energy and enthusiasm, which launched the N.I.R.A. in its early days, be put behind a campaign for accelerating capital expenditures, as wisely chosen as the pressure of circumstances permits? You can at least feel sure that the country will be better enriched by such projects than by the involuntary idleness of millions.

I put in the second place the maintenance of cheap and abundant credit and in particular the reduction of the long-term rates of interest. The turn of the tide in great Britain is largely attributable to the reduction in the long-term rate of interest which ensued on the success of the conversion of the War Loan. This was deliberately engineered by means of the open-market policy of the Bank of England. I see no reason why you should not reduce the rate of interest on your long-term Government Bonds to 2½ per cent or less with favourable repercussions on the whole bond market, if only the Federal Reserve System would replace its present holdings of short-dated Treasury issues by purchasing long-dated issues in exchange. Such a policy might become effective in the course of a few months, and I attach great importance to it.

With these adaptations or enlargements of your existing policies, I should expect a successful outcome with great confidence. How much that would mean, not only to the material prosperity of the United States and the whole World, but in comfort to men's minds through a restsration of their faith in the wisdom and the power of Government!With great respect, Your obedient servant
J M Keynes

Thursday, November 4, 2010

Here is a statement by Ben Bernanke over the Federal Reserve's recently policy decisions. Please feel free to ask if you don't understand a particular part of the article. Also pay attention to the last 2-3 paragraphs. We talked about this in class.

This is the goal of the Fed's policy:
(1) Push more businesses to expand capacity and hire workers
(2) Push the dollar downward and make American exports more competitive and therefore generate more jobs
(3) Allow more Americans to refinance their homes at low rates, thereby giving them more cash to spend and thereby stimulate more jobs.

Wednesday, November 3, 2010

I'm a strong supporter of carbon taxes (and no I'm not a hippie). The carbon tax policy is supported by economists across the political spectrum. Donald Marron held various appointments in the Bush administration. The idea is simple, tax items that impose an added cost to society and use the revenue to reduce personal income taxes and pay down the government debt.

Which country places the highest price on pollution? The surprise is the country that is number 2. This suggests the U.S. can increase carbon prices and still be competitive on global markets.

Monday, November 1, 2010

Here is a piece by Tyler Cowan. Something that I haven't thought directly about, and that is firms with access to low skilled immigrant labor (legal or illegal) or more likely to keep operations in the United States opposed to moving overseas where there is cheap labor. This means saving a number of skilled jobs involved with the management and daily operations of domestic firms.

Sunday, October 31, 2010

It appears the economy is still growing, kinda. Here is a nice a review by one of my professors at Oregon. There is one glaring issue. The economy grew at a 2% rate, but that is mostly due to a change in business inventories. In the next few chapters we are going to spend a lot of time looking at the components of GDP. Business inventories are particular interesting, as they are also an indicator of future GDP. An increase in business inventories suggests businesses anticipated selling more today than they actually sold. Of course, the increase could be because firms are building inventories prior to the holidays. Nonetheless, when they accumulate inventories GDP increases and when they sell off their inventories GDP will decrease.

Other interesting things to note:
1) Personal consumption increased at a 2% rate.
2) Equipment and software grew at a 12% rate. Firms are making more investments, that's good.
3) Residential investment decreases at a 29% annual rate. This is a stark turn from the second quarter when residential investment increased at a 25% annual rate. Of course the first-time homebuyer credit expired in the middle of the second quarter.
4) Imports increased at a much faster pace than exports (17% to 5%)

Monday, October 25, 2010

The recent Nobel Prize winning economist Peter Diamond was appointed to the Federal Reserve Board of Governors by President Obama. Peter Diamond is more than qualified to serve on the Board. He is only an expert in public finance and structural unemployment.

On Wednesday we will begin talking about monetary policy. To help a struggling economy the Federal Reserve will lower interest rates by increasing the amount of money available for banks (through an increase in reserves). Remember banks are able to lend out excess reserves. The interest rate influenced by the Federal Reserve is called the federal funds rate. The federal funds rate is a short-term interest rate that is determined in the federal funds market. The federal funds market is where banks borrow and lend to other banks. A bank that needs more reserves can borrow from other banks. It's not uncommon for a bank to make to many loans and have a shortage in their reserve account. When the Federal Reserve lowers the federal funds rate they will increase the amount of excess reserves in banks, with more reserves in the banking system, banks will lower interest rates to attract more lenders. During the recent recession, the Federal Reserve has increased bank reserves by nearly $800 billion, but banks have not increased loans meaning long-term interest rates have not come down and the money supply has remained relatively unchanged. More importantly, investment has remained low.

To help encourage more borrowing, the Federal Reserve has taken steps to reduce the long-term interest rate. This process is called quantitative easing. Normally a lower short-term interest rate will lower long-term interest rates. Long-term interest rates are an average of short-term rates. Despite having short-term interest rates near zero, long-term rates remained high. Long-term interest rates were high because banks were worried about future mortgage defaults and government deficits. The solution was for the Federal Reserve to directly buy long-term debt instruments. This would reduce yields on long-term debt, which will hopefully increase borrowing.

To date the Federal Reserve has purchased $1.4 trillion in long-term debt. You can see their balance sheet here (for those interested you would want to look at reserve bank credit). This is the size of the banks balance sheet, if you look back a few years you will notice a large increase.

More shocking is this report by Goldman Sachs that says the Federal Reserve will need to purchase an additional $4 trillion in long-term debt. This behavior will create inflationary concerns.

Investors are accepting negative returns on TIPS. Remember TIPS pay the bond holder a nominal return plus the inflation rate. If they are willing to accept a negative nominal return it must be they are expecting higher inflation.

Note:
Yes there is a lot of political pressure to protect American jobs. Most politicians understand there are benefits and costs when it comes to trade. Normally the benefits outweigh the costs (job losses). The job losses are concentrated in states that have historically relied on manufacturing. These states (i.e. the rustbelt) are also political swing states. Again this is the difference between economics and politics.

Remember a country's currency is priced relative to another country. The yuan is priced at 7, which means it takes 7 yuan to buy 1 dollar. If the yuan appreciates it will take fewer yuan to buy a dollar. It terms of trade, if the yuan is low (undervalued) then one dollar can purchase a lot of yuan (and subsequently a lot of goods). As the yuan appreciates the price of Chinese imports increases, and U.S. exports decreases.

Fortunately most countries price commodities in terms of dollars. A lower value of the dollar won't have a large impact on the price's because the commodities won't change.

I have updated everyone's blog participation scores so I could provide relatively updated midterm grades. You can access the blog scores here.

If there is a mistake and you feel I missed one of your posts let me know. I do have a couple of user names that I am unclear on. If you have not been posting, I strongly recommend you start posting. I will be happy to give you half credit for missed posts.

I have submitted midterm grades. The grade submitted represents your blog participation (I will factor use attendance and classroom participation at the end of the course in determining your final grade), one quiz score (your lowest score is dropped), and 4 homework scores (your lowest score is also dropped). I elected to drop only one homework score when calculating your midterm grade, this way your grade is not biased upward.

If you feel I made a mistake, please contact me sooner rather than later.

I know a number of students have expressed frustration over not clearly articulating the role of the blog when evaluating class participation. I know I have mentioned the need to make 1-2 blog posts per week. We discussed the blog the first day of class and in the syllabus. Further I emailed the following to everyone a week before classes:
Fifteen percent (originally ten percent) of your grade is based on course participation. This is your participation in the course blog. I will post articles, write ups, and other interesting economic events on our blog. It is your responsibility to actively follow the blog and make comments. You do not need to comment on all the postings, but at least once a week you need to sit down and make an effort. The course blog is public domain, but the only access is through the URL. It will not show up through a search engine. This should keep your posts relatively private. You can create a user name, just make sure I know the real name behind it. You are not judged based on your views, you are judged on your ability to articulate and argue those views. I will generally update the blog 2-3 times per week.

I'm sorry if you feel that I was not clear in my expectations, but I don't know what else I can do without feeling like I am constantly nagging students to make posts. I am giving everyone a chance to make up missed posts for half credit. Please take advantage of this.

Tuesday, October 19, 2010

As we talked about in class, saving today is good for future economic growth. But as we shift away from consumption the economy will worsen in the short-run. Clearly this has important policy implications. So what's the solution. Well apparently it's a little of both. We need to spend and save.

What policies can we implement. I still think the number one problem is household debt. Many households own more on their homes than what they are worth, throw in consumer debt (credit cards and car loans) and student loans it's easy to see why households are reluctant to spend. A well structured loan modification program will reduce household monthly debt payments. This needs to be followed up solidifying the Bush Tax cuts for at least the households earning less than $250,000, and with investment tax credits for businesses.

Monday, October 18, 2010

Are commodities experiencing a bubble? As we move into monetary policy and the determinants of inflation this article is of particular interest. As the Federal Reserve injected trillions of dollars into the financial system (to keep interest rates low) a number of investors are betting inflation is just around the corner. As of today banks are flush with cash, but are not issuing loans. This behavior is likely keeping inflation low, but the concerns over high future inflation are increasing. There are two ways to hedge inflation risk, buy treasury protected securities or invest in commodities (gold).

We know bubbles are contagious, after one bubble ends another bubble forms. It's usually just a matter of time before another bubble is spurned.

Here's a nice piece in the NY Times. The article does mention economists agree on many issues, but ultimately divergence arises under very subjective issues. The underlying issue is equality. What's fair? The article talks about taxes in particular. Is making someone pay $10,000 when they earn $100,000 equally as fair as taxing someone $4,000 that earns $20,000? Does it matter how they earn that income? Going beyond how they earn the money, but who's right is it to decide how much we pay in taxes?

We all have different opinions, even among economists. When issues become subjective in nature it is difficult to come to a reasonable solution. This is part of the story behind the current debates over extending the Bush tax cuts.

Obama wants to extend the American Opportunity Tax Credit. This credit allows households with income less than $80,000 a tax credit up to $2,500. The average tax credit is nearly $1,700.

In class we've talked about the need to shift taxes away from things that are productive into a consumption based tax. I like this extension. With the rising prices of college it is a huge break for middle income families. This also provides more fuel to my argument, why should anyone pay taxes on money that is being used to send their children to college. We have established 529 college saving plans which act as a tax shelter, but unfortunately most households are not taking advantage of these benefits. If they were then we wouldn't need these income tax credits. Further, the households that are using the 529 plans are generally higher income. So again the middle income families are facing larger tax burdens.

Instead of having to create these tax credits and the necessity for 529 saving plans a simple switch from an income tax to consumption based tax would solve a number of problems.

Monday, October 11, 2010

The Economist has a nice image of global debt levels. The debt recorded is public debt. For the United States this amount is about $8 trillion dollars. Our current national debt is about $13 trillion, this means $5 trillion is held about other government agencies. If you look at public debt as a percentage of GDP the United States is not nearly as bad as many other countries. This doesn't make it better, just not as bad.

Saturday, October 9, 2010

1:10 Section
Question 1: You need to think about how income is earned. All income is tied into the production of something. At the end of the production process the final market value of an items is compensating workers and owners for their contribution to the production process.
Question 2: Can be found in the practice questions for Inflation on Connect
Question 3: Changes in inflation are zero sum (people are neither richer or poorer), but inflation does have a cost. The main cost is a reduction in economic growth, but you should have also listed redistribution of income.
Question 4: Was completed in class when we discussed globalization and wage inequality. The demand for labor in the high skilled industry increases (wages increase) and the demand for labor in the low skill industry decreases (wages decrease). Supply does not change.
Question 5: Promote saving and investment, human capital, and a better legal system

2:10 Section
Question 1: GDP only accounts for production it ignores other factors that have improved our standard of living. These include health care, education, environment, and leisure time.
Question 2: Can be found in the practice questions for Inflation on Connect. The one catch is in 2009 the price of chickens increases to $6.00 and ham to $12.00. If people are indifferent between 2 chickens and 1 ham, given the new prices their bundle will not change (hams cost twice as much as chickens). There is no substitution bias.
Question 3: Can be found in the practice questions for Wages and Unemployment on Connect. If 65% of the working age population is in the labor force than 35% of the working age population is not in the labor force. In other works .35x = 52.5 or 150 million in the working age population. Which means the labor force has 150 - 52.5 or 97.5 people. If 5.5 % of the labor force is unemployed than the economy has 5.36 million workers unemployed and 92.14 million workers employed.
Question 4: Real wages have risen because of a shift in labor demand (technology making workers more productive). Over the last 25 years the growth in real wages has slowed because of an increase in labor supply (baby boomers and woman).
Question 5: The four poverty traps are landlocked, natural resources, bad governance, and civil war.

Tuesday, October 5, 2010

Obama announced a massive push in promoting community colleges. This is huge! We've talked about the higher levels of unemployment for low skilled workers and this is one potential solution. The only people upset over the proposal for profit colleges! I wonder why? I'm not a huge fan of for profit higher education. Lately there have been many issues surrounding how for profit college (i.e. University of Phoenix and Kaplan) exploit the financial aid system. So when they come out swinging, it makes me think it's a good idea.

But not everyone is on board with the effort. Organizations like Kaplan, the University of Phoenix, and various for-profit colleges are lashing out at Obama's plan, charging that community colleges are being showered with too much presidential attention and federal aid at the expense of other institutions.

In other words the federal aid will be going to lower income families that want to attend community colleges, which happen to be a fraction of the price of for profit colleges. Many for profit colleges cost nearly the same to attend as private schools. For profit colleges exploit the financial aid system leaving the students in debt and often without any employment after graduation. Here's a nice video by Frontline on for profit colleges.

The net wealth held by American households has decreased by $17 trillion dollars following the housing market meltdown. Here's a nice review. Households will continue to increase saving to help offset the losses in housing equity and retirement accounts. This will only prolong the current recession. Again we are seeing the major difference between short-run and long-run factors. Increased saving in the short run will worsen the current recession, but will put us a more sustainable path in the future. This is especially true with the large fiscal deficits.

Tuesday, September 28, 2010

I know we just went through the labor market where we discussed the factors affecting labor supply. The main factors were the birth rates, baby boomer generation, woman entering the labor force, and retirement age. I didn't go into a lot of detail about immigration. This is primary because illegal immigrant do not affect the labor supply in the United States. They are taking jobs American do not want to work. This is evident by the United Farm Workers campaign, "Take Our Jobs". They have opened up 700,000 jobs current occupied by immigrants. Only 16 people have applied for these positions (including Stephen Colbert). Here is nice piece by Ezra Klein.

So how can more immigration increase the wages of low skilled American workers?

Monday, September 27, 2010

In the 2:10 section when talking about low skilled workers we got sidetracked talking about sweatshops where I made the comment sweatshops are good. Going in, I know this view is not in the majority, but at a minimum I ask that everyone keep an open mind. I know a number of students are passionate about this issue, as am I, so please be civil.

When I think about sweatshops this article (and these here and here and here) come to mind. Are sweatshops good? No. When comparing the alternatives for people living in poverty sweatshops do offer one avenue for hope and in that scope they are good. We've seen millions of people come out of poverty because of sweatshops not despite of.

My point is that bad as sweatshops are, the alternatives are worse. They are more dangerous, lower-paying and more degrading. And when I struggle to think how we can really make a big difference in the development of the poorest countries, the key always seems to be manufacturing. (Kristof)

Impoverished families need to find sources of income, if we force firms into paying higher than market wages (multinational companies already pay 2-3 times the wages of domestic manufacturing firms) fewer workers will be hired (law of demand). This will leave a number of people unemployed, they will be forced to find alternative sources of income. This is where the real exploitation begins. Families will sell children into the sex trade. There is a growing problem with human trafficking, the solution lies in more manufacturing firms not less. If this means more sweatshops, then yes please give me more sweatshops. Here's Paul Krugman's take.

Workers in those shirt and sneaker factories are, inevitably, paid very little and expected to endure terrible working conditions. I say "inevitably" because their employers are not in business for their (or their workers') health; they pay as little as possible, and that minimum is determined by the other opportunities available to workers. And these are still extremely poor countries, where living on a garbage heap is attractive compared with the alternatives.

Pressuring firms into paying higher wages will simply result in the firms leaving the least developed countries for middle income countries that offer the opportunity to shift production for low skill labor to machines. What happens to the workers in the least developed countries?

Now can we have less human trafficking while paying above market wages to manufacturing workers in developing countries? I don't know. So far the evidence suggests not. Would I like to see firms pay these workers higher wages? Yes, but the reality of our economic model (i.e. capitalism) places large constraints on firms that will likely prevent this from happening. Corporations face tremendous pressure to maintain high levels of profit. We bet on these firms to keep increasing profits which comes at an unfortunate cost. As long as society demands high returns and/or low prices we will continue to have sweatshops. The global recession will only increase this pressure. This does not mean countries can't outgrow the need for sweatshops. Export led growth has been hugely beneficial for many Asian and Latin American economies (Brazil, China, Singapore, Philippines, Indonesia, Japan, Taiwan, Korea, and many others). We've seen a number of economies grow from the stages of sweatshops into economic powers (including the United States). Sweatshops may not be necessary but so far they've proven to be sufficient. I'm not sure I want to experiment with an alternative model that may lead to more children being sold into the sex trade.

As a country we can do something. We can stop subsidizing agricultural production which will help restore jobs in many developing countries. The United States is responsible for destroying the lives of many farmers. Farm subsidies in the United States have created an excess supply of many agricultural commodities that we have dumped on the world market. This excess supply has created artificially low prices and forced a number of farmers off their land into manufacturing jobs (or into the U.S. as illegal immigrants). By removing farm subsidies a number of workers could leave factory life, return to farming, and wages will increase for those in the manufacturing sectors. This will help prevent the food shortages experienced across many developing nations. Here's another piece by Kristof.

As the nation-state developed, individuals felt connected to others within the nation—not as closely as to those in their own local community, but far more closely than to those outside the nation-state. The problem is that, as globalization has proceeded, loyalties have changed little. War shows these differences in attitude most dramatically: Americans keep accurate count of the number of U.S. soldiers lost, but when estimates of Iraqi deaths, up to fifty times as high, were released, it hardly caused a stir. Torture of Americans would have generated outrage; torture by Americans seemed mainly to concern those in the antiwar movement; it was even defended by many as necessary to protect the United States. These asymmetries have their parallel in the economic sphere. Americans bemoan the loss of jobs at home, and do not celebrate a larger gain in jobs by those who are far poorer abroad.

Most of us will always live locally—in our own communities, states, countries. But globalization has meant that we are, at the same time, part of a global community.

Thursday, September 23, 2010

William Easterly argues more trade, not less, is needed to help the poor. I completely agree, instead of increasing trade barriers we need to reduce them. As the U.S. passes more protectionists policies it's only a matter of time before other countries follow suit.

Tuesday, September 21, 2010

Given we are currently talking about inflation I thought this article in the New Yorker might be relevant.

Why inflation might be good, two reasons. First, it helps reduce the real value of household and government debt. As you know, we have a lot of debt. Second, it creates an incentive to spend on goods today.

Paul Krugman and Robin Wells have a good review of the causes of the financial crisis. I am firmly in the group that believes the "global saving glut" played a large role in our financial crisis.

The Global Savings Glut

The term “global savings glut” actually comes from a speech given by Ben Bernanke in early 2005.1 In that speech the future Fed chairman argued that the large US trade deficit—and large deficits in other nations, such as Britain and Spain—didn’t reflect a change in those nations’ behavior as much as a change in the behavior of surplus nations. Historically, developing countries have run trade deficits with advanced countries as they buy machinery and other capital goods in order to raise their level of economic development. In the wake of the financial crisis that struck Asia in 1997–1998, this usual practice was turned on its head: developing economies in Asia and the Middle East ran large trade surpluses with advanced countries in order to accumulate large hoards of foreign assets as insurance against another financial crisis.

Germany also contributed to this global imbalance by running large trade surpluses with the rest of Europe in order to finance reunification and its rapidly aging population. In China, whose trade surplus accounts for most of the US trade deficit, the desire to protect against a possible financial crisis has morphed into a policy in which the currency is kept undervalued, which benefits politically connected export industries, often at the expense of the general working population.

For the trade deficit countries like the United States, Spain, and Britain, the flip side of the trade imbalance is large inflows of capital as countries with surpluses bought vast quantities of American, Spanish, and British bonds and other assets. These capital inflows also drove down interest rates—not the short-term rates set by central bank policy, but longer-term rates, which are the ones that matter for spending and for housing prices and are set by the bond markets. In both the United States and the European nations, long-term interest rates fell dramatically after 2000, and remained low even as the Federal Reserve began raising its short-term policy rate. At the time, Alan Greenspan called this divergence the bond market “conundrum,” but it’s perfectly comprehensible given the international forces at work. And it’s worth noting that while, as we’ve said, the European Central Bank wasn’t nearly as aggressive as the Fed about cutting short-term rates, long-term rates fell as much or more in Spain and Ireland as in the United States—a fact that further undercuts the idea that excessively loose monetary policy caused the housing bubble.

Indeed, in that 2005 speech Bernanke recognized that the impact of the savings glut was falling mainly on housing:

During the past few years, the key asset-price effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported record levels of home construction and strong gains in housing prices.

What he unfortunately failed to realize was that home prices were rising much more than they should have, even given low mortgage rates. In late 2005, just a few months before the US housing bubble began to pop, he declared—implicitly rejecting the arguments of a number of prominent Cassandras2:—that housing prices “largely reflect strong economic fundamentals.”3 And like almost everyone else, Bernanke failed to realize that financial institutions and families alike were taking on risks they didn’t understand, because they took it for granted that housing prices would never fall.

Despite Bernanke’s notable lack of prescience about the coming crisis, however, the global glut story provides one of the best explanations of how so many nations managed to get into such similar trouble.

Here's a good article discussing the consequences of Americans shifting into more saving and reducing household debt. I've mentioned before, the result will be slower economic growth over the next decade, but this will put us in a better financial position to address social security and health care. We need to create more incentives for households to save, one example could be a switch from an income tax to a spending tax (or a value added tax). Right now we are taxing any income that is not spent buying a home, paying for college, given to charity, or saved in retirement plan. We are not encouraging households to save money. We need to allow households to save money in relatively liquid accounts without paying income taxes. This saving will further reduce our dependency on foreign investment.

Here is a discussion on the Economist about teaching economics and the crisis. A lot of the discussion is focused on upper/graduate courses, but the reading list proposed by Michael Bordo is particular interesting. At Oregon I required all my students in my money and banking course to read, "Manias, Panics, and Crashes" by Charles Kindleberger. At Gonzaga I teach an course entitle "Economics of Financial Crises". The two books that I have required students to read are "This Time is Different. Eight Centuries of Financial Folly" by Carmen Reinhart and Ken Rogoff and "Manias, Panics, and Crashes." For anyone wanting to better understand the crisis start here. In my intermediate macroeconomics course next spring "The Time is Different" will be required reading.

Here is a survey posted on CNN that shows 60% of economists want Bush's tax cuts extended for all income levels. This isn't far from what I've suggested. There are two forces at work: the recession and government debt. In the short run we need the economy to recover, but we can't afford to keep the tax cuts permanent. Let's extend the tax cuts for all income levels and then starting in 2013 slowly phase in tax increases for the upper groups. To help offset the tax cuts we need to find spending cuts, but again lets not implement those until 2015 or later if the economy is still slow.

Does it seem like prices have been increasing over the last year. Well the have been, but we're not going to call it inflation. Recent inflation data show prices have increased at annualized rate of 1.1%. This is a fairly low number and could further push the economy into decline. Despite modest inflation in what we call the core CPI overall prices rose 4.4%. This number includes energy and food prices. We normally strip away these food and energy because they are highly volatile and don't paint an accurate picture of prices. In the last few years we had oil prices spike due to speculative trading, this summer wheat prices have spiked due to the first in Russia, and other commodities (coffee for example) are rising in response.

The Federal Reserve does not worry about rising energy and food prices simply because these are outside of their control.

Thursday, September 16, 2010

China has increased their purchases of Japanese yen. This action will cause the yen to appreciate and the yuan to depreciate. China's goods will be less expensive relative to Japans'.This is important for a couple of reasons. First China must see increased competition from Japanese exports. Second they are moving away from dollar dominated assets. The latter could prove costly for the United States. Right now we are heavily dependent of foreign purchases of US debt. If China is committing to Japan's debt this could cause a depreciation in the dollar. As investors expect the dollar to decline they will demand greater interest rates. In the end, this could greater increase the cost of running large government deficits.

Wednesday, September 15, 2010

Most students lost points on numbers 2 and 3. Here are some thoughts I had while grading the quizzes.

#1 Identify the flaw in this analysis: ”If more Americans go on a low-carb diet, the demand for bread will fall. The decrease in the demand for bread will cause the price of bread to fall. The lower the price, however, will then increase the demand. In the new equilibrium, Americans might end up consuming more bread than they did initially.”

A lot of people are going around and around with this problem. Demand decreases because of people's preferences. The result is a new equilibrium where price and quantity have declined. The lower price is the result of a change in one of the determinants of demand (preferences). End of story. A lower price does not in turn increase demand.

A common mistake is to assume those not on the low-carb diet will increase their consumption and demand will increase. At the original equilibrium, stores will realize fewer people buying bread. A surplus will emerge. Stores/bakeries must lower prices to sell the excess bread.

#2 Consider the following events: Scientists reveal that consumption of oranges decreases the risk of diabetes and, at the same time, farmers use a new fertilizer that makes orange trees more productive. Illustrate and explain what effect these changes have on the equilibrium price and quantity of oranges.

(This problem is similar to the last five problems in the practice set supply and demand)

Demand will shift to the right (increase) causing price and quantity to increase. Supply will shift to the right (increase) causing price to decrease and quantity to increase. In the end we know quantity will increase but the effect on price is indeterminate.

Common mistakes were saying price stayed the same or having a definitive answer. There were a handful of answers that incorrectly shifted supply (an increase is a rightward/downward shift). Finally, a few people forgot to illustrate the effects.

#3 Residents of your city are charged a fixed weekly fee of $6 for garbage collection. They are allowed to put out as many cans as they wish. The average household disposes of three cans of garbage per week under this plan. Now suppose that your city changes to a tag system. Each can of garbage to be collected must have a tag affixed to it. The tags cost $2 each and are not reusable. What effect do you think the introduction of
the tag system will have on the total quantity of garbage collected in your city?

(This problem is similar to our discussion on overeating at all-you-can-eat buffets. Also see the practice set on the introductory material).In the first case, the cost is $6 per week no matter how many cans you put out, so the cost of disposing of an extra can of garbage is $0. Under the tag system, the cost of putting out an extra can is $2, regardless of the number of the cans. Since the marginal cost of putting out cans is higher under the tag system, we would expect this system to reduce the number of cans collected.

You need to have mentioned marginal cost in your answer or have some reference to it. Most students discussed that on average the quantity won't change because those that original consumed more than 3 cans would decrease their waste while those that consumed less than 3 cans would increase their waste. The key to getting credit for this problem is recognizing the price per can has increased from $0 to $2.

#4 What’s the best way to think about the rise in oil prices in the last 10 years, as China and India have become richer: was it a rise in demand, a fall in demand, a rise in supply, or a fall in supply? Why?

China and India represent more buyers in the market. As the number of buyers increase demand will shift to the right, causing quantity and price to increase.

A lot of people fell into the trap that as China and India increased their demand for oil, the supply must have fallen. My guess is you're thinking of oil being in fixed supply, but you need to think about the market. Was less oil supplied to the market? No, their might be less oil in the ground, but this doesn't mean supply fell.

We won't spend a lot of time on the stock market, but I thought the first two stocks were interesting. Anyone know why McDonalds and Campbell's Soup would increase during a recession (here's the link)? During the stock market panic of 2008, Campbell's Soup was the only company that did not experience a decrease in their value when the Dow Jones Index fell 777 points (the largest one day point loss).

Tuesday, September 14, 2010

This post is about a week early, as next week we will begin talking about unemployment. Nonetheless, The Federal Reserve Bank San Francisco published a recent letter discussing the future of declining unemployment rates is conditional on the movement of workers back into the labor force. During the recession a number of workers left the labor force. These workers went back to school, became stay at home parents, etc. They are discouraged workers. As the economy improves nearly six million workers will have to decide whether they want to reenter the labor force. The speed at which these workers find jobs will dictate the future unemployment rate.

Sunday, September 12, 2010

The average for the first homework assignment was 81.3%. Here are the three most missed problems:

#4 (35% correct) Larry was accepted at three different graduate schools, and must choose one. Elite U costs $50,000 per year and did not offer Larry any financial aid. Larry values attending Elite U at $60,000 per year. State College costs $30,000 per year, and offered Larry an annual $10,000 scholarship. Larry values attending State College at $40,000 per year. NoName U costs $20,000 per year, and offered Larry a full $20,000 annual scholarship. Larry values attending NoName at $15,000 per year.

The opportunity cost of attending Elite U is

$50,000

$10,000

→

$20,000

$15,000

The correct answer is $20,000. The question is asking for the opportunity cost of attending Elite U. Recall opportunity cost is the value of the next best alternative. In this case, Larry would receive a value of $20,000 by attending State U.

#6 (40% correct) Amy is thinking about going to the movies tonight. A ticket costs $7 and she will have to cancel her dog-sitting job that pays $30. The cost of seeing the movie is

$7.

$30.

→

$37.

$37 minus the benefit of seeing the movie.

The correct answer is $37. The question is asking for the cost, not the overall value. I suspect those that got the question wrong answers $37 minus the benefit of seeing the movie. If Amy starts the night with $10 and goes to work she will have $40. If she goes to the movie instead she's left with $3. The difference between the two options is $37.

#3(58% correct) Dean decided to play golf rather than prepare for his exam in economics that is the day after tomorrow. One can infer that

Dean has made an irrational choice.

Dean is doing poorly in his economics class.

→

the economic surplus from playing golf exceeded the surplus from studying.

the cost of studying was less than the cost of golfing.

The correct answer is the "economic surplus from playing golf exceeded the surplus from studying". I suspect most people answered "the cost of studying was less than the cost of golfing". Suppose the cost of studying was $0 and the cost of golfing was $10. Wouldn't you choose to study if you were basing you decision off of costs alone. The key in this question was Dean did golf which means he received at least more value (or surplus or warm fuzzy feelings) from golfing. This question is a lot like our classroom example where you had to decide between the two concerts. If you went to the Bruce Springsteen concert than you must have received more than $10 in surplus or you would have gone to the Bob Dylan concert.

As you probably realize the economies of China and the United States are more intertwined than ever. Over the last two decades China focused their domestic policies toward export lead growth. This was primarily achieved through a pegged exchange rate. The lower the value of the yuan the cheaper it was for Americans to covert dollars into yuan and buy more Chinese goods. Foreign investors began flocking for Chinese firms. As foreign money flowed into China normally the yuan would appreciate. An appreciation would make exports more expensive and slow down manufacturing in the export sectors. To offset the added demand China would increase their money supply and use the money to buy U.S. denominated assets. These policies allowed China to have a large trade surplus with the United States, conversely a large deficit for the United States.

There are costs to maintaining a pegged exchange rate. During the financial crisis the United States increased the money supply, i.e. lower interest rates, to stave off a financial panic. As more dollars enter the economy the value declines relative to foreign currencies. This would cause the yuan to appreciate unless the Chinese government undertook the same policies (by pegging the yuan to the dollar China is effectively adopting U.S. monetary policy). Here's the concern for China, their economy is starting to grow relative to the United States, but they cannot maintain their pegged exchange rate without risking double digit inflation rates. They are faced with an appreciation of the yuan or higher inflation both will increase the cost of Chinese goods on the global market. Unfortunately, I don't see this being overly beneficial to the United States. Our manufacturing does not complete directly with China, it won't immediately cause jobs to return to the U.S., and it will result in higher prices to households.

Saturday, September 11, 2010

This claim is true in part; lower tax rates on the high income earners are obviously beneficial for those earners. Yet this is only part of the story. To stimulate work, saving, and investment, tax cuts have no choice but to favor the taxpayers who respond most to taxes, as well as those likely to save and invest. That means high income earners. So policy must accept some inequality in exchange for more efficiency.

In theory this is true, but the reality is not nearly as neat as Mirron would like. The wealthy barely responded to the initial tax cut, will there by a lot of change if the tax rates on those making $250,000+ increase?

And in the case of dividend and capital gains taxation, the economy can have its cake and eat it too. These taxes appears to hit wealthy capitalists, but in reality they fall partly on consumers, via higher prices, and on workers, via lower demands for their services when corporations shut down or move overseas. So low taxation of dividends and capital gains helps both low and high income taxpayers.

Warren Buffet has said repeatedly that he does not think it's fair that he pays a lower tax rate than his house cleaner. For those that earn income on investment (via capital gains) they pay an tax rate of 15%. This is lower than more pay on earned income. A lower capital gains tax allows for riskier behavior. One can not writing off the reduction in the capital gains taxes in 2003 as a potential cause of the housing bubble. All of the sudden those make speculative real estate purchases were paying less in taxes.

President Obama is opposed to extending the Bush tax cuts and is instead proposing to allow full write-off of business investment through 2011. This proposal is reasonable, but the impact is likely to be small; this policy merely allows businesses to deduct investment now rather than later as depreciation. Given currently low interest rates, this shifting of expenditure is not worth much.

A different problem with the president’s approach is that it emphasizes short-run stabilization, not long-run efficiency. To prosper over the long haul, the economy needs certainty about taxes, rules, and regulations, not ever-evolving policy initiatives.

Mirron is right on here. Obama needs to allow business to deduct the full amount of their investments permanent. A one year benefit will only create more uncertainty. I have address the uncertainty of a patchwork policy framework in a previous post. We need to end uncertainty over governmental policy. This could have been done two years ago when we passed ARRA. We should have addressed the tax cuts (my view is to extend the cuts for all tax payers and then in 1-2 years have a slow increase for the high income earners perhaps conditional on economic growth), to counter the impact on future deficits we can offset the tax cuts with reductions in spending (but not until 2015).